by Lawrence Meyers | December 6, 2013 9:23 am
It’s up for debate whether the soaring stock market is being driven by artificial demand, as bond buyers have been redeploying capital since rates are so low, or if earnings justify the move in both the market and individual stocks.
Regardless, there are plenty of pundits who think the market has gone too far and is overdue for a serious correction.
So, what should you do if you have concerns?
One possible strategy that might help you sleep at night is to hedge some of your positions using covered calls. In this case, I’m talking about using LEAPS on blue chips, which will yield substantial premiums that will both hedge against a down move in the market, and not leave you too unhappy if your position gets called away.
Still, I suggest you sell calls against half your position, allowing you to collect premiums on some of your blue chips, while still not risking the rest being called away.
Philip Morris International (PM) is a great choice in this arena. Here we have a massive company selling an addictive — and very popular — global product.
As I write, PM stock trades at $85.51, and the Jan 2015 $87.50 calls are selling for $3.80. First of all, you get a 4.34% premium, which is generous on a large-cap LEAP. So you are protected down to $81.71. Sure, the stock could fall more, but the point isn’t to eliminate all downside risk, but rather to hedge against it.
Now, here’s the beauty of using this particular company: PM stock pays a 4.4% yield, or $3.76 per share. Because you still hold the underlying stock, you collect the dividend as long as that stock doesn’t get called away. If Philip Morris stock ends at $85.51 come expiration, you still will have earned a total of 8.74%. If the stock gets called away, you will have collected the same amount in dividends and premiums anyway.
Thus, for the deal to be a loser for you on the upside, the stock will have to close at $93.07. And you can always buy it back before, during or after it gets called away.
Hershey (HSY) is also a strong choice. This is a world-class brand that is known all over the world, and has expanded well beyond chocolate!
As I write, HSY stock trades at $95.79, and the May 2014 $95 Calls are selling for $5.38. First of all, you get a 5.66% premium, which you’ll note is much larger than Philip Morris’ despite only selling about 12% higher. The reason for the higher premium here is the smaller dividend of 2%, or $1.94 (97 cents is all you’ll get since HSY stock will pay out two dividends by May).
In this case, you are protected down to $89.44, or 6.7%, because you get that dividend since you haven’t formally sold the stock. 6.7% is accounting for a pretty significant downdraft! And furthermore, should Hershey stock ends at $95.79 come expiration, you still will have earned that 6.7%.
For the deal to be a loser for you on the upside, the stock will have to close at $102.14.
One other play here is McDonald’s (MCD), and it’s instructive because it trades at $95.43, almost the same as Hershey.
The June $95 calls go for $3.85 (4% premium), and the dividend is 3.3%, or $3.24 per share (or $1.62 over the two payments until June). So with MCD stock, we have just one additional month on expiration compared to Hershey, but only a 5.65% total return due to the dividend.
In this case, I’d actually go out to the Jan 2015 $95 Calls and collect $5.40 in premium plus the full dividend, for an 8.95% total hedge (or upside).
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.
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